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Sunday, March 2, 2008

More on India's budget

Finance Minister Palaniappan Chidambaram's budget speech on Friday once again reflected the government's mounting concern that a vast majority of Indians are not benefiting from the economic boom. The budget was laced with populism, involving giveaways systematically targeted at major vote banks. Spending hikes were announced in education, health care and a rapidly expanding employment guarantee program. Tax concessions were thrown in to keep the middle class engaged, and the manufacturing sector also got some relief in the form of a 2% reduction in the value-added tax.

But this budget will be most remembered for a massive $15 billion loan waiver that covers a large part of all outstanding farm loans -- and constitutes 3% of the entire banking system's credit portfolio. Apart from being the single biggest write-off in recent memory, this one measure also reveals a lot about the government's current mindset. It shows how eager the government is to reach out to a vote bank of 40 million workers at any economic cost and also demonstrate how keen it is to co-opt the communist parties' slogan of "compassion" towards the poor.

More importantly, the loan waiver suggests that the few reformers at the helm of economic affairs can no longer keep out bad ideas. From the outset of this government's formation in May 2004, it was clear that the main agenda of the reformers in power -- and the finance minister has to count as one of them -- was to prevent spending from spinning out of control rather than to usher in any new reforms. This is partly because of the way the last national election results were interpreted. Just because the then-ruling Bharatiya Janata Party's "India Shining" campaign line didn't work with voters in 2004 -- the first year of a step-up in India's growth trajectory -- the political class impulsively came to the conclusion that economic performance doesn't matter.

The strident call from political quarters following that election was to engage in a tax-and-spend policy mix. Mr. Chidambaram was largely able to keep spending under control by repackaging old plans, giving the impression to his political masters that the government was indulging in pursuing more inclusive growth. Consequently, India's total fiscal deficit continued to narrow to 7% last year, from a peak level of 10% in 2002. Such consolidation was largely achieved by strong revenue growth of 25% over the past four years, running well above the nominal gross domestic product growth of 14%.

But over the past year, fiscal discipline began to show signs of some serious cracking, and the biggest sign of slippage was this Friday's budget. Even though Mr. Chidambaram projected a decline in the central government's headline deficit to less than 3% of GDP, it has become routine in India to fund oil, food and fertilizer subsidies outside of the budget by issuing separate government bonds and not including them in the budget calculations. Subsidies on these items have been rising rapidly due to the sharp increase in international prices. The government has only passed a small part of the price increases to the consumer. By most estimates, the budget deficit would be higher by more than 2% of GDP after incorporating these off-budget subsidies.

The budget deficit is likely to come under further pressure if India's growth rate moderates even slightly in line with global trends. The torrid pace of expansion over the past few years has led to robust corporate profitability and in turn strong revenue growth. Typically, corporate revenues tend to be very sensitive to cyclical changes in GDP growth. Given the prospect of a global slowdown, the finance minister would have served the local economy and finances better by cutting India's corporate tax rate, which at a peak level of nearly 34% is much higher than levels in East Asia.

The economy could have also done with some further supply-side stimulus to ease infrastructure bottlenecks with a cut in customs duties. A spirited supply-side response is the best antidote to stagflation -- the whiff of which is currently in the air across the world. As in many other emerging markets, Indian monetary authorities are more consumed with fighting inflation, leaving the onus of ensuring continued economic momentum to other policy tools.

It would have been helpful to buy some insurance against the souring of global business sentiment caused by all the negative news emanating from the United States. Mr. Chidambaram could have kept alive the animal spirits by announcing further economic liberalization. Interestingly, the finance ministry released its annual economic survey just a day before the budget. The document listed many potential reform measures for the government, ranging from private participation in coal mining to further opening up retail and insurance sectors to foreign investors.